Bernie and Pam Britten are a young married couple beginning careers and establishing a household. They will each make about $50,000 next year and will have accumulated about $40,000 to invest. They now rent an apartment but are considering purchasing a condominium for $100,000. If they do, a down payment of $10,000 will be required.
They have discussed their situation with Lew McCarthy, an investment advisor and personal friend, and he has recommended the following investments:
The condominium - expected annual increase in market value = 5%.
Municipal bonds - expected annual yield = 5%.
High-yield corporate stocks - expected dividend yield = 8%.
Savings account in a commercial bank-expected annual yield = 3%.
High-growth common stocks - expected annual increase in market value = 10%; expected dividend yield = 0.
Calculate the after-tax yields on the foregoing investments, assuming the Brittens have a 28% marginal tax rate (based on Public Law 108-27, The Jobs and Growth Tax Relief Reconciliation Act of 2003).
How would you recommend the Brittens invest their $40,000? Explain your answer.
Buying the condo requires borrowing money: What is the interest rate they would have to borrow on? Wouldn't that make a great difference, a loan of say one percent vs a loan of ten percent?
What are their family plans...do they have children coming on their minds?
(along with this...what are the restrictions on the condo...family, resale, subleting...etc)
Financial planning is not easy. Investing in a home is financial security issue as well as a financial investment issue.
Have you calculated the after-tax yields on the proposed investments? That's the place to start.
As you think about what to recommend for the $40,000 investment, remember that after they pay a down payment on a condo of $10,000, they'll only have $30,000 left to invest. I'd still recommend buying the condo, if the mortgage payments, association fees, and utilities come to 30% or less of their take-home pay.
They should also keep a substantial amount -- at least $10,000 -- in liquid funds like a savings account. Since they're young, I suggest they put $10,000 in common stocks, realizing they could lose a substantial portion of it in the short term -- and depending upon their investments -- the long term, as well.
To calculate the after-tax yields on the investments, we need to consider the tax implications for each investment option. Let's break down the calculations for each investment:
1. The condominium - The expected annual increase in market value is 5%. Since this is a capital asset, the increase in its value is not subject to immediate taxation. Therefore, the after-tax yield remains 5%.
2. Municipal bonds - The expected annual yield is 5%. Municipal bond interest is generally tax-free at the federal level and, in some cases, at the state and local levels as well. Thus, the after-tax yield remains 5%.
3. High-yield corporate stocks - The expected dividend yield is 8%. Dividends received from stocks are generally subject to taxation. At a marginal tax rate of 28%, the after-tax yield would be calculated as (1 - 0.28) * 8%, which equals 5.76%.
4. Savings account in a commercial bank - The expected annual yield is 3%. The interest earned on savings accounts is subject to taxation. At a 28% marginal tax rate, the after-tax yield would be (1 - 0.28) * 3%, which equals 2.16%.
5. High-growth common stocks - The expected annual increase in market value is 10%, and there is no dividend yield. The increase in market value is not subject to immediate taxation. Therefore, the after-tax yield remains 10%.
Now that we have calculated the after-tax yields for each investment option, let's consider how the Brittens should invest their $40,000.
Considering the after-tax yields, the highest-yielding options are the condominium (5%), municipal bonds (5%), and high-growth common stocks (10%). Both the condominium and municipal bonds offer similar after-tax yields of 5% and are relatively stable investment options. The high-growth common stocks have potential for a higher return, but they also come with higher risk.
Based on the Brittens' financial situation and their goal of establishing a household, it might be prudent for them to consider diversifying their investments. One possible recommendation would be to allocate a portion of their funds to the condominium (say $20,000) as a long-term investment for potential growth in market value. They could then allocate $10,000 to municipal bonds for stability and tax advantages. The remaining $10,000 could be allocated to the savings account in the commercial bank for liquidity and security.
This allocation would provide a balance between potential growth, stability, and liquidity while considering their tax implications. It is important for the Brittens to also consult with a financial advisor to assess their risk tolerance, long-term financial goals, and any other individual circumstances before making investment decisions.